What is the point of accounting? Providing economic history or predicting the future?

That is the underlying question raised by Prof. Charles M. C. Lee in a speech he gave which is summarized in an article at the Stanford graduate school of business website: Charles Lee: Why Fair-Value Accounting Isn’t Fair.

Let me help you stretch your brain. After writing this article, mine hurts. (Okay, okay, I hear you saying it doesn’t take much to strain Jim’s brain.)

The professor’s full speech is here. I read the first third of the paper, up to the point he starts talking about stock valuation theory. Good stuff.

One sentence summary from the article:

Lee argued that fair-value accounting confounds and confuses the core purpose of rigorous accounting. That purpose, he contends, is to provide economic history — an accurate report on transactions that have already occurred.

One great paragraph from the speech:

The market has come to rely on accountants as the keepers of economic history. As an investor, when I turn to the financial statements, I want a trustworthy and interpretable account of what took place. A corporate chronology might not be as exciting as science fiction, but at least we know what we are reading relates to economic events and transactions that really took place. As soon as we start to anticipate future exchanges, we are into a world of speculation, and unfortunately (given dysfunctional managerial incentives and other moral hazard problems), it is often also a world of fiction.

I will summarize his points to the extent I understand them. Errors in presentation are mine obviously.

The purpose of accounting is to aggregate information about what has happened. We recognize income, expenses, assets, and liabilities based on completed transactions.

The stock market makes a collective estimate as to what the discounted present value of future earnings will be. That collective estimate is expressed as a stock price.

If I follow the professor’s argument, fair value accounting moves us from reporting what has actually happened in the past to estimating what will happen in the future. In other words recognizing income and expenses is based on what we think will take place later.

Let’s look at a simple example I thought of – marketable securities. It used to be that accounting would report what was actually paid to buy the securities. Balance sheet would report historical cost.  Notes would disclose the market value.

Consider what fair value does to that concept. Now we’re estimating the future cash flow using as a proxy what the stock market says the security is worth as of the balance sheet date. This means we recognize income or loss for transactions that haven’t taken place. The transactions might not take place for years or decades, but we take the gain or loss today.

At a large-scale, we do the same thing with goodwill.

Is the market value (i.e. discounted present value of future cash flows) less than historical cost? If so, then take a hit to earnings. Write it off.  Recognize in income that the present value of all future earnings are now less than they were estimated to be when the goodwill was recorded.

Look at it from a different conceptual perspective: built in to that goodwill writeoff is your estimate of the entire future stream of earnings for the company.

How about tax accounting?

Let me boil down one part to an over-simplified description. A deferred tax asset can be recognized up to certain limits.

Let me rephrase that concept in light of the professor’s presentation:  Determining the upper limit on the deferred tax asset involves estimating the amount of taxable income for whatever length of time needed for all differences to reverse. All you need to do is estimate taxable income for the next 3 or 20 years.

That means you, the preparer, are predicting the future. You, the auditor, are opining on that prediction of the future.  I think the professor would say that is also recognizing current gains (deferred tax asset) based on future earnings and opining thereon.

More and more items are being brought into fair value accounting.

The end point of applying fair value accounting

If the purpose of financial statements is to report fair values, then the professor suggests the ideal financial statement would be listing the market capitalization of the stock as total equity and the change in market cap from year-to-year as net income.

Let me flesh out that idea.  We could add up the market value of outstanding bonds to fill out the liability side. Sum the market cap of stocks and bonds to get total assets. Not quite sure how we get to gross revenue.  Would not be necessary to address contingent liabilities, because the stock market has already discounted the impact of reported negotiations for settlements of major litigation and federal enforcement action.  The financials are done.

That would adjust everything on the financial statements to fair value.

Let’s extend the exaggerated impact of fully implementing fair value accounting on the entire financial statement –

Think of the time companies could save. The entire accounting system would need nothing other than a receivables, payables, and payroll module.  Audit fees would drop by 98% or more. Sitting here as a one person CPA firm, I could audit GM or Microsoft, since I have a paper and electronic subscription to the Wall Street Journal. CPAs who don’t have those subscriptions could access the free side of Morningstar.

Apple in 2013 as an example

Professor Lee uses Apple in 2013 as an illustration. The company had record gross revenue and second best net income in its history. Simultaneously the stock price dropped a lot.

On one hand, GAAP revenue was at record high and net income was near record.

On the other hand, stock market returns were lousy which means expectations for the future are gloomy.

Which is correct?

Let me rephrase:

On one hand, the economic history (GAAP accounting basis) showed it was an incredible, fantastic year.

On the other hand, the estimated, present-value discounted, future earnings (stock value which is change in stock price determined by the collective decisions in the market) aren’t as large as a year ago.

I think they are both correct. Current year was the best ever and future years won’t be as great as were previously expected.

Knowing both stories will allow investors to make their own estimates of future cash flows.

The professor says we accountants ought to give investors the economic history.

(My brain hurts. Hat tip: tweet from Professor Catanach @GOAcatanach, )

What do you think?

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